In a surprising turn of events, convertible bonds have become the go-to financial instrument for Chinese companies seeking to raise capital. This trend, led by tech giants like Alibaba and JD.com, is breathing new life into Hong Kong's capital markets and offering a unique blend of low-cost financing and potential equity upside for investors. As interest rates remain high and traditional equity markets face challenges, convertible bonds are emerging as a strategic tool for companies looking to optimize their debt structures and fund overseas expansion.
In recent months, a wave of convertible bond issuance has breathed new life into Hong Kong’s anaemic capital markets. Since late May, four major Chinese internet and technology companies—JD.com, Lenovo Group, Alibaba Group, and Trip.com - have successively issued convertible bonds totalling $10.5 billion.
Notably, Alibaba’s $5 billion issuance set a record for the largest U.S. dollar-denominated convertible bond by an Asian company. This issuance and others have lifted the spirits of Hong Kong’s bankers and lawyers hoping for a prompt revival of Asia’s erstwhile fundraising powerhouse after a persistently subdued IPO scene so far threatened to choke the city’s investment prospects.
Jonathan Stone, partner and head of global transactions at Skadden, Arps, Slate, Meagher & Flom in Hong Kong, and counsel Vincent Sze point out that an increasing number of companies are using convertible bonds as an alternative source of funding.
“Many of the issuers are U.S.-listed (or dual U.S./Hong Kong-listed) companies with substantial PRC operations, particularly in the technology sector. We believe that this trend is likely to continue while interest rates remain high and primary equity market issuances remain challenging,” say Stone and Sze.
Tian Mingzi, a partner at Jingtian & Gongcheng based in Beijing, believes a warm reception to large-scale convertible bonds can “boost market confidence and attracts more investors,” thereby “increasing trading volume and liquidity in Hong Kong's capital market.”
The issuance of convertible bonds by China concept stocks is not something new. However, the combination of global macroeconomic pressure and China’s policy directives makes the latest round unusual.
"Amid the current high interest rate environment, the low stock prices of China concept stocks, and China's supportive policies for overseas financing and outbound business expansion, these companies are issuing convertible bonds to improve their debt structure, expand overseas operations, and repurchase shares,” explains Tian.
Taiki Ki, a capital markets partner at Linklaters in Hong Kong, points out that the trend of companies issuing equity-linked financing instruments has been seen globally over the past few years in a rising interest rate environment.
“However, with the recent rebound in Chinese equities, we are seeing significant renewed interest in this product in 2024," notes Ki.
This optimistic sentiment is shared by Skadden’s Stone and Sze. They believe that convertibles and other equity-linked products often serve as a gateway to primary equity markets.
“The hope is that the financing activity from convertible bond issuances and similar transactions will drive other deals, particularly IPOs, of Asia-based issuers,” say Stone and Sze.
EQUITY SWEETENERS
For issuers, one of the primary attractions of convertible bonds is their low funding cost. Under this circumstance, equity-linked instruments such as convertible bonds will remain popular as the value of the embedded equity will lower interest payments, according to Ki.
Take Alibaba as an example: The interest rate on its recent convertible bond is 0.5 per cent. However, the rate on comparable term ordinary bonds previously issued by Alibaba would have exceeded 5.1 percent, according to estimates from market institutions.
"Before conversion, convertible bonds can swap high-interest debt for low-interest debt. After conversion, they can lower the debt ratio and improve the company's debt structure," Tian explains.
Another perceived advantage of convertible bonds is the instrument’s ability to help well-performing domestic companies expanding overseas gain higher access to foreign exchange reserves and reduce transactional losses caused by exchange rate fluctuations.
In addition, convertible bonds have been increasingly winning the favour of investors. Apart from lowering interest payments in a high-rate environment, “such instruments offer significant arbitrage opportunities between the bond and the underlying equity for certain types of fund investors, allowing such investors the ability to manage volatility arising from external factors such as market movements and for issuers from certain regions and political tensions,” Ki adds.
Given these characteristics, convertible bond issuances tend to be popular amongst industries such as technology, the internet, new energy, and biotech.
"These sectors have high growth potential, high capital needs, and significant stock appreciation potential. From the perspective of both the company's financing costs and the investor's returns, convertible bonds are more appealing," notes Tian.
What made Chinese technology companies one of the biggest players in this space recently was their robust balance sheets and a strong credit profile, coupled with volatility in the share price that bumped up the value of embedded equity option.
As such, equity-linked securities, including convertible notes "offer a compelling narrative for investors through the combination of strong downside protection with potential for equity up-side, including from investment grade companies which historically may have been able to source pure debt financing at a cheaper cost,” explains Ki.
CONVERTIBLE STRATEGY
The recent wave of convertible note offers have had a notable common feature: Issuers such as JD.com, Alibaba, and Trip.com have concurrently executed share buybacks in a bid to ease any dilution effect.
Indeed, there has been initial skepticism that any future conversion of bonds into shares might dilute the company’s equity. But, as Tian explains, concurrent share repurchases can offset the dilution effect, attracting long-term investors who are bullish on the company’s growth, thereby supporting the company’s sustained development.
Convertibles issuances pared with a share buyback from the issuers are intended to match two significant liquidity events, according to Ki. Those are “the hedging from convertible bond investors” and “the share buyback from the issuer for a highly efficient execution with minimal disturbance to stock price”. Ki believes that it is beneficial to both the issuer and the investors.
Skadden’s Stone and Sze note that apart from making stock purchases, some issuers have also used a portion of the proceeds to purchase derivative instruments (known as call spreads) from the underwriters, which have the effect of raising the effective conversion price for the issuer.
Beyond flexible combinations, convertible bonds could also be strategically tailored to meet company needs. For instance, while some notes were offered to the public, Lenovo Group targeted a specific $2 billion zero-coupon convertible bond to a subsidiary of the Saudi sovereign wealth fund.
"This illustrates the breadth of financing strategies involving convertible bonds, from pure fundraising and enhancing capital structure to strategic investments," says Ki.
Tian further unpacks the variety of strategic purposes underpinning convertibles issuances. "Some convertible bonds are publicly offered, typically by companies with higher ratings and better market reputations, attracting more investors and boosting market confidence,” she says.
“Others are aimed at specific buyers, showcasing the close relationship and potential for further cooperation between the investor and the company. Companies will choose issuance strategies based on their specific circumstances and needs,” Tian adds.
All in all, lawyers agree that the approach that an issuer takes largely hinges on its objectives and the level of perceived demand for the funding instrument from different classes of investors.
In addition, “some issuers may choose to pursue private transactions to enable negotiation of more bespoke terms than would be available from a wider investor base, target a smaller number or particular type of holder (e.g. longer-term holders such as sovereign wealth funds) or for strategic reasons (e.g. the holder may provide business synergies to the issuer),” say Stone and Sze.
